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Functions of Foreign Exchange Market
Welcome friends. In our course of International Business, now we have started this veryimportant concept of foreign exchange the forex market. So, we discussed in the lastlecture what is this foreign exchange.We have heard of you know stock exchanges right. So, where stocks are exchangedpeople buy and sell shares. So, similarly the foreign exchange market is aninternationally international financial market which is a 24 hour market and here thetransaction between different currencies are happening are happening right.So, when somebody wants to buy you know buy dollars or it can buy Indian rupees or itbuys euro or it by sterling whatever. So, yen. So, the major currencies. So, it can formaking any transaction between 2 different countries you need a vehicle, you need acurrency basically that is acceptable to the other partners.So, in order to do that to make this business easy foreign exchange comes handy ok. So,in the last lecture we discussed about what are the who are the participants in this foreignexchange market. So, we talked about the central bank, the commercial banks, thecorporations, the individuals you know the fund managers right, the fund agencies andyou know all these different the brokers.So, there are 6 basically people who are involved and how it is. So, how it is importantthat you need to be very careful in the foreign exchange market because here it is playedon a very huge volumes right. In fact, if you remember I had said that we almost spentabout the amount of transaction that happens is more than 6 trillion US dollars per dayright. So, that is an enormous amount of money right.So, any difference; that means, the large players who play on arbitrage and you knowwho work on hedging of funds and all, they work on very small fractions very smallportions, but those amounts are very huge again because of the sheer size.(Refer Slide Time: 02:26)So today we will continue with this lecture and we will first understand what are thefunctions of the foreign exchange market. So, the foreign exchange market basically has3 functions. As you can see one is called the transfer function, the other is called thecredit function and the third is called the hedging function.So, the first function let us start is a very easy and which says the transfer of purchasingpower or clearing function. The basic function of that foreign exchange market is tofacilitate the conversion of one currency into another right. So, rupee to dollar, dollar toyen yen to sterling sterling to pound whatever. The transfer function is performedthrough the use of credit instruments such as bank drafts bill of foreign exchange andtelephone transfers right.Examples are for example, remittances or education fee made through transfers ok. If anAmerican businessman plans a trip to India he exchanges US dollars for Indian rupeesbecause if he wants to you know eat a dosa or a paratha in India he cannot pay in USdollars because nobody is going to take his US dollar.Many people might not until and unless the hotel or restaurant is a very big one and theyaccept the dollars they are separate thing, but otherwise it is not possible. So, to make itis business trip sound or it is you know for to even to visit for any these are trip theyneed the Indian currency. So, all these exchanges is a first job that the foreign exchangemarket does. This is the first job. So, transfer function.The second important function of the forex is that the foreign exchange market providescredit to both national and international players to promote foreign trade. Suppose anIndian company wants to purchase machinery from US right some capital intensivemachinery from the US. It can pay for the purchase by issuing a bill of exchange right. Inthe foreign exchange market, essentially with the 3 month maturity.So, that credit how would this credit be given. So, to give this credit there is a 3 monthmaturity period which is a given right. On basis of this, the foreign exchange marketprovides a credit at some maybe some benefits some small benefit right.So, this credit facility the provision of credit facility helps the buyers to buy you knowinstruments or technology or anything which for which they do not have moneyimmediately or even sometimes it is not wise to pay the money because they would try totake some time unnecessarily they have a they can get a 3 month period.So, that trade off has to be seen now which is how much beneficial and the company cantake it stance. But, whatever the provision of credit is an important function of the forexmarket right.(Refer Slide Time: 05:29)The third is the provision of hedging facilities. Now, I explained the last lecture thathedging means we mean covering of a foreign exchange risk right arising out of thechanges in exchange rates.Now, suppose you have purchased something and because you know after purchasingsuddenly the price the you know that the value of the currency, but that has been used thedollar has changed. Now, because of this change you might make a loss right you have topay more now right.So, in this case the when you have to pay a more dollars that is a loss. So, such a loss in asmall business is still ok. But when you are talking about millions and millions oftransactions and of you know millions of millions of rupees or money in that conditioneven a small fraction even 1 percent change can make a tremendous impact right.So, when exporters and importers to enter into an agreement to sell and buy goods onsome future date at the current price and the exchange rate it is called hedging. So whathappens here? The exporter and importer have entered into an agreement to sell and buythe goods on some future date at the current price and exchange rate.So, the rate would be maintained. The purpose of hedging is to avoid losses that might becaused due to the exchange rate variations in the future let us see. An Indian exporter hasmade export worth 1,000 dollars right. So, he has made an export worth 1,000 dollars. Inthis time period, suddenly what has happened. The current spot exchange rate is 1 dollaris 60 rupees ok.So, how much you would get? He has made a export of let us say handicrafts. So, he hashe will get 60,000 rupees 60 * 1,000 at the set date suppose after 3 months ok. Now, ifthe rupee appreciates in between to 50 now 1 dollar has become rupee is 50. So, thatmeans, the rupee has become stronger right.So, after a maturity he will only get now how much? Now 50 into 1,000. So, 50,000. So,that means, there is a loss of 10,000 due to the appreciation right. So, that is why it issaid many a times when the value of the when the currency appreciates it is bad forexports right and it is good for imports right.So, now he can hedge his position by signing a contract with the financial institutionafter payment of the hedge premium. So, he pays a hedge premium. I want to get the only 60 rupees worth of my product right. So, at least is the rupees 60 issafe. In case had it depreciated you would have got 70,000. Had it appreciated he wouldhave got 50,000. Now, he is getting neither a loss nor a profit at least the worth of hisproduct. Now, what factors are affecting the exchange rate right?(Refer Slide Time: 10:13)So, foreign exchange rate is one of the most important means through which a country’srelative level of economic health is determined right. Obviously, because all thetransactions and businesses are done through this foreign exchange right. A country’sforeign exchange rate provides a window to its economic stability which is why it isconstantly watched and analyzed.So, there are people who are constantly watching and analyzing it because a smallchange can have a big effect right. For example, imagine a country like China which ishighly export oriented. Now, if the Chinese currency yuan appreciates what will happento the exporters. So, entirely the if China is let us say exporting 100 billion dollars worthof goods and the yuan appreciates by let us say 10 percent.So, that means, on 100 billion it on 10 percent is simply 10 billion. So, there would be aloss of 10 billion. This is only a mathematical calculation 10 billion just because therehas been a currency change right. So, it may. So, you can understand how important thisthing is. It may fluctuate daily with the changing market forces of supply and demand ofcurrencies from one country to another.So, that you cannot have a control. The entire world is connected right. So, I am buyingfrom oil from Iran I am selling now I am making some products out of it and I am sellingthose products to let us say Cambodia, I am selling this products to Australia.Now, the Australia is using this products the Australian companies and they are makingsomething. So, the whole world is like chained. So, they are all tied up right. So, it is likesomething like one chain somewhere will have an influence and some other place alsoright. So, it the.So, it has to be very one has to be very careful in understanding the supply and demandprinciple in the foreign exchange market right. So, for example, how much demand ofthe dollar is there today right? Is the dollars demand going is increasing or it is remainingsame or is it decreasing.Suppose let us say the dollars value or importance will decrease with time; that means,what. Less countries will trade with the dollar with the you know, but the US dollar right.So if they trade less with the US dollar the need for US dollar will be less. So, if the needfor the US dollar will be less the importance of the US dollar goes down automaticallythe US you know position of power with also get affected right.(Refer Slide Time: 12:53)Factors some of the factors that affect the exchange rate are for example, relative interestrates, the inflation rate, the income level of your country or the people right, theintervention of the government as you know sometimes the RBI intervenes to control themoney market right, the political stability and performance.Now, you know the exchange rate for a place which is highly volatile and highly youknow is always into war and civil rights and all and to in comparison to another countrywhich is highly a peaceful country would be different. Country’s current accountdeficits, government debt and speculation. So, you can see. So, these are the differentyou know the variables or the factors that affect the fact the exchange rates ok.(Refer Slide Time: 13:41)So, let us see let us go one by one. So, the first is the relative interest rate. Now, what itis saying? Australia’s interest rate increases related to other countries. So, the interestrate that Australia has is increasing right. Investors will get a better return on Australianassets.So, the Australian dollar increases in value to the rise in demand. Now, if you understandnow because the interest rate has increased, so the Australian bank let us say is payingmore. So, the people would like to invest more in Australia because by investing they aregetting more interest rates right.So, what he says higher interest rates offer lenders in an economy a higher return relatedto other countries. Therefore, higher interest rates attract foreign capital and cause theexchange rate to rise. Now, this has happened also with India very recently right.So, the Indian government recently what has happened some of the foreign players theytook away their money right and they fled off. So, this has resulted in a not only thechange in the exchange rate, but also it affected the stock market the stock exchange verybadly right. So, this has happened because of not only one reason, but many. One ofthem being the political stair reasons also right.The impact of higher interest rates is mitigated or lowered, however if inflation in thecountry is much higher than in others right. Now, what it says suppose x the governmentis paying the banks are paying higher interest rates. Now so, to pay if they are payinghigher interest rates.So, people if I put in my money let us say I will get higher interest rates. So, more moneyI will earn at the end of the year, but the point is this is this will be nullified alright. Thiswill be a lowered if the inflation in the country’s much higher than others. If the inflationis higher; that means, the cost of purchasing my basic commodities or goods is alsohigher.So, the amount of money that I am generating I am losing out on the other side by payingmore money right in buying the goods right. So, if additional factors serve to drive thecurrency down what that is what it is saying.The opposite relationship exists for decreasing interest rates that is lower interest ratestend to decrease the exchange rates right. So, what happens when there is a lower interestrate. So, people are not interested to put in money in your country right. So, the exchangerate or the value of your rupee will be will go down right.(Refer Slide Time: 16:24)Similarly, the second important thing is the inflation rate. So, all these are connected, butthen still we are trying to see it in a discrete fashion ok. A higher rate of inflation willmake a country’s currency less attractive. So, if the inflation is high; that means, as I saidbuying is costly.So, the currency will become less attractive right because it is value has come down withless with more money you are able to buy less goods right because of the loss of the realvalue with the inflation. So, if with 100 rupees I was able to buy let us say 2 kg ofpotatoes right.Now, with let us say let us take the case of onions. If 100 rupees I was earlier buying 2kg 3 kg of onions today I am able to buy only 1 kg of onions. So, that is; that means, thebecause this has led to an inflation the in the inflationary price.Now, this has and if it happens to more number of products then the cost of the thingsgoes up right. Countries with consistently high inflation rates tend to have lowercurrency values right. This is because purchasing value decreases related to the othercountries and vice versa.You see this example Venezuela’s hyperinflation rate increased from 902 to 10 millionpercent since 2018 according to the International Monetary Fund. So, you know thatVenezuela’s currency completely was destroyed right this the economy was shatteredright.So, it went into an hyperinflation rate stage where you know you had to have you knowloads of money even it happened in Zimbabwe where you they had they had to you knowprint currencies of 1 million worth each right notes of 1 million. So, in such higherinflation or hyperinflation states also it has a very negative effect on the exchange rate.You see this example. This means that the price for goods in the UK increased quickerthen European goods. So, UK goods will be less competitive demand for UK exportswill fall and so there will be less demand for the sterling. This is the example we aretrying to talk about inflation rate right.So, euro and UK right. So, you can now connect maybe with the condition that if in theBrexit Britain is now trying to come out of the that group. So, will it have a good effector a bad effect you. This is for you to think right and come out with some make of somelogical conclusion. The third point is the relative income level.(Refer Slide Time: 19:10)Now, citizens with higher incomes right look for new consumption opportunitieswherein as the income increases people think of new consumption opportunities in othercountries, driving up the demand for those currencies and shifting the demand curve tothe right.Now for example, the income of people in India increases right. So, as the demand as theincome increases. So, the what they will do they will try to look for newer opportunities.Let us say the newer opportunities what they are looking for are some luxury items orproducts which are not available in India, but they are only available in some othercountries like Italy or France.Now, to buy those goods to buy those products maybe its perfume or car or leather bagsor something they have to use the you know franc or you know sterling or whatevercurrency of the country is. So, that drive the demand for that currency now goes up right.So, thus as income rises in one country the prices of foreign currencies rise as well andthe local currency will depreciate right. So, now, if the local currency will depreciate yousee this is like a tug of war right.So, if the local currency will depreciate what will happen now exports will gain right, butimports will lose an import you will lose because you will have to pay more right. So asa local currency will depreciate right. So, when you when the local currency depreciatesexports will gain because people can buy at a lesser price more products, but importswhile doing imports you have to pay more dollars right. The government interventionsthe fourth point.(Refer Slide Time: 21:03)Buying and selling of foreign currency in the market by the central bank as the Reservebank for example, in India with a view to increasing the supply or demand therebyaffecting the increase the increase the exchange rate right is known as intervention.So, there has been a lot of debate on this how much should the central bank intervene. Infact, the central bank role is to intervene, but by intervening they affects the exchangerate. So, what to what degree should they intervene? How much intervention is correct atwhat point of time is always a debatable issue right.So, the governments may influenced the equilibrium exchange rate by imposing foreignexchange barriers, imposing foreign trade barriers, intervening in the foreign exchangemarket and affecting macro variables such as inflation, interest rates and income levels.Let us look at this example.China wants to keep it is currency undervalued to make Chinese exports morecompetitive right because as I said earlier also China is largely explore driven economyright. So, it would not it would like to keep it is currency undervalued so that people canbuy more of Chinese products. China sells it is yuan and buys up US dollars right.With less supply of US dollars the value of the yuan decreases. With less supply of USdollars the value of the yuan decreases. Compared to the now higher dollar the yuan isrelatively cheaper. So, as you see value of yuan related to the USD and quantity. So, itsays when you know this happens the government intervene sometimes. In fact, in Chinain Japan the currency was devalued so that it would help their exports right. So, that alsohas a very large impact on the exchange rate.(Refer Slide Time: 22:59)You look at this example. In 2007, India experienced rapid appreciation of its currencyagainst the US dollar in 2007. The reason for the appreciation where a generally weakdollar in the international currency market.So, the dollar had become weak and sharp increase in dollar inflows into the countrypartly due to India’s increasing attractiveness to the foreign investors right. So, theforeign investors found India to be an attractive market. They wanted to set up their ownplants. They set up they wanted to have assets in India. They wanted to put money in thestock market.Although India had been seeing a steady rise in dollar inflows into the country for quitesome time, the RBI intervened in the foreign currency market and purchased the excessdollars so as to avoid any appreciation in the value of the rupee because if the RBI hadnot intervened; that means, what would have happened the rupee would haveappreciated.And had the rupee appreciated what would have happened. The exports would have gotaffected the. There would have been an adverse affect on the exports of Indian exportsright. So, major Indian businesses which are lying depending on exports they would haveseriously got affected right.On November 24, 2016, the rupee hit a record low of 69.09. Now, it is 71 right, slidingpast it is earlier trough of 68.86. So, to curb the Indian currencies fall now the currencywas falling, the RBI sold 400 to 500 million in the spot market right in some time right.So, what happened?What does the RBI do? The RBI is holding this dollars right the currency and at sometime it would like to buy right or in some time other time it would like to sell off. So,here in this case when it was at a record low the and it was going up again it was going69 70 towards.So, that to curb the Indian currency is fall the so the Indian currency would not belooking week, the RBI sold of the you know sold 400 to 500 million dollars. So, byselling of the dollars it wanted to stop that fall off the Indian currency.So, these points are very very interesting and they need to be very carefully understood.So, if once you understand them then it will be very clear to you how internationaltransactions are happening and how each one is getting affected by the other right.September 2018, India raised the import duty on a range of items including airconditioners, refrigerators, washing machines, footwear, jewellery, furniture fittings andtableware. Besides imposing it on aviation turbine fuel ATF as the government seeks torein in the current account deficit and shore up the rupee.So, the Indian government right raise the import duty. So, it by raising the import duty,so what it did was it made the domestic players more competitive and the outside playersor the external players less competitive right.Although it is not advised it is always criticized by the WTO, but still sometimes lookingat the local condition and the income level and the you know people’s condition thegovernment does it right. So, the government tried to help the rupee right. The next pointis the political stability and performance.(Refer Slide Time: 26:44)Now, a country’s political state and economic performance can affect its currencystrength right. So, as I said if there is a lot of violence, unrest, civil rights and all itaffects the performance of the currency.The foreign investors inevitably look seek out stable countries with strong economicperformance in which to invest their capital because everybody is scared. Had if there awar if there war goes on inside the country, then how would we get back our moneyright. In fact, in some of our classes I have explained or maybe in the future I willexplain how you know these things get affected when there is an violence or adisturbance in a country.A country with such positive attributes will draw investment funds away from othercountries perceived to have more political and economic risk. No wonder for some of theAfrican nations some of the other nations which have always been into some kind of awar, turmoil they have been not able to attract investments right.If an economy is growing at a faster rate in the long run it is generally expected to have abetter performance on the balance of trade right. Political turmoil for example, can causea loss of confidence in a currency and a movement of capital to the currencies of morestable countries.So, if tomorrow India has a lot of disturbance be it for any reason internal reason I justwant just do not wanted to name anything, but for any reason there is a instability in ourcountry, then the foreign investors would not be very much interested.And I am not surprised today to the stock market there is a disequilibrium and themarkets are not doing that great. Although at one point the nifty is growing the sensex isgrowing, but other side many shares are not doing well. So, many stocks are not doingwell. So, the point is such kind of a loss of confidence can be a bad thing for anycountry. So, political stability is very very important.If markets feared the US would default on it is debt, foreign investors would sell theirholdings of the US bonds. This would cause a fall in the value of the dollar. So, this isthe one of the greatest fights that is happening right which that is the common man is notmuch aware of that because US has a lot of debt right as is one of the highest is thecountries with the highest debt, but and it knows very well that if the people will belosing confidence or they will be scared then they would run away and they would notput in their money.But, and if the US dollar does not stay strong. In fact, then US power or hegemony or theyou know point of the position of power they would lose it right the supremacy. So, thereis a constant fight with the oil countries oil you know exporting countries and all of usand U.S is trying to have the shell oil and other things so that it can control this dollarsyou know value right. So, this fight of dollar is not linked only to the financial market,but it goes out to the you know to the real war also right sometimes.(Refer Slide Time: 30:02)Let us take this example. Vietnam for example, is controlled entirely by the ruling party.The economy is one of the most volatile in Asia. What once was thought of being apromising economy has recently been in distress. Vietnam’s macro economy wasrelatively stable in this period 97 to 2006 it is low inflation is 7 to 9 percent outputexpansion annually and a moderate level of trade deficit.But Vietnam could not bother the adverse impact from the 1997 98 Asian financialturmoil which happened in the 97 98 time which partly curbed the FDI flow its economyinto it is affected the exchange rate. Starting in late 2006 both public and private sectorfirms began to experience structural problems rising inefficiency and waste of resourcesbecause of political instability.So, political instability has a tendency to outweigh any positive outcomes from currentgovernment and related currencies will usually suffer loss. What it means is simply thegovernment may intervene to do lot of things you might do lot of good things, but thepoint is if there is an instability in a country.For example, the there is no clear government and there is lot of disturbance, then theoutside players would not show interest because they will be always afraid of thebecause of the stability or instability the country you know the value of their currencywill fall right.So, today what we have learnt is we have tried to understand what are the differentfactors that affect the foreign exchange and some of them being for example, the politicalstability instability and the you know inflation, the interest rates, the governmentsintervention etcetera. So, we will continue with this you know factors affecting theforeign exchange market in the next lecture.So, thank you very much for the day. Have a nice day.